Mortgage chaos is hurting the US recovery
Federal regulators and state attorneys-general are trying to reshape US policy on mortgages. About time. Policy up to now has been a shambles. It is one reason why the recovery has been so weak - and why the US housing mess is capable, even now, of snuffing out the expansion altogether.
The idea is to take advantage of the foreclosure scandals that hit the mortgage business last year. By then, the volume of foreclosures in the US had grown so large, and the process (because of loan securitisation) so complex, that formalities were often dispensed with. Rules were broken, documents lost, papers signed without being read. Homeowners had their properties improperly seized. As all this came to light, thousands of foreclosures were suspended, worsening the paralysis in the US housing market.
The regulators and the attorneys-general are negotiating a settlement with the biggest mortgage servicers - including banks such as Bank of America and Wells Fargo. With the threat of multibillion-dollar fines to focus minds, they are pressuring servicers to write down more loans.
The emphasis on writing down principal is right. If it had been there from the beginning, the recovery would have been stronger. The administration's housing market policies have failed because, through bad design and pitiful execution, they have modified loans mostly by cutting interest rates and extending repayments, not by reducing debt. As a result, as house prices have continued to fall, the problem of negative equity has grown and keeps getting worse.
This vicious circle has throttled the recovery. Negative equity makes it harder for the unemployed to sell up and move to new jobs. It also causes defaults. In the US, mortgages are typically non-recourse loans, so when the mortgage exceeds the value of the house, it makes sense for borrowers to let the lender foreclose. Foreclosure is slow and costly. Houses stand empty and unmaintained, shedding more value and driving down prices of houses nearby. People are evicted; savings are destroyed; recovery is held back.
Economists such as John Geanakoplos and Luigi Zingales have insisted from the beginning that much of this toll was and still is avoidable. The key point is that, for strictly selfish reasons, lenders should want to write down principal so that borrowers can stay in their houses and maintain them. That way, the value of the property, and the lender's interest in it, stays higher than it would be under foreclosure. The cycle of negative equity and default should be self-moderating, not self-reinforcing.
Why then have so few loans been written down? This is much disputed. Banks may be worried about encouraging additional defaults, or they may be deceiving themselves (or their shareholders) about the chances of recovering the loans' full value. At any rate, it is clear that securitised loans have posed a particular problem. Servicers of securitised mortgages are once removed from the interests of the underlying investors, and have had too little incentive to avoid the losses caused by foreclosure.
A main task for policy was, and still is, to force servicers to co-operate. One way would have been to take the foreclosure process out of their hands and give it to government-appointed trustees (as Mr Geanakoplos suggested). Another would have been to give borrowers with negative equity the option to reduce their principal in exchange for surrendering a share of any future appreciation to the government (as Mr Zingales proposed). The problem with ideas such as these was never the cost. In fiscal terms, they would cost next to nothing. In economic terms, they might save a fortune. But they are bold, would have had to be explained to the public and would have needed legislation. In Washington, that makes three fatal defects.
Instead the Treasury has resorted to a string of perpetually tweaked and retweaked schemes tacked on to the troubled asset relief programme or other initiatives. Their common flaw has been to rely on voluntary co-operation from mortgage servicers - and, despite exhaustive evidence to the contrary, on servicers' competence.
The flagship scheme was the home affordable modification programme. Earlier this month Neil Barofsky, the Tarp's special inspector general, delivered a withering assessment to Congress. He said Hamp "benefits only a small portion of distressed homeowners, offers others little more than false hope, and in certain cases causes more harm than good". Remarkably, because of failed "trial modifications", participation in the scheme has often left borrowers with "more principal outstanding on their loans, less home equity, depleted savings, and worse credit scores".
The new effort to bounce servicers into reducing principal has the right goal. The past two years have shown that coercion, in spite of the industry's complaints, is not just wise but necessary. However, the new approach yet again is indirect and lacks clarity. If it is ever implemented, it will be complex, arbitrary in coverage and legally insecure. At best it means further delay and will help too few borrowers. All to avoid the political risks of admitting failure and making a big, bold case for what needs to be done. In the Obama administration, unfortunately, avoiding risk counts for a lot.